Consumer Price Index (CPI)

The Consumer Price Index is a measure of the change in the average price level of a fixed basket of goods and services purchased by consumers.

In the US, this number is published by the Bureau of Labor Statistics. The index shows the change in price levels since the index base period, currently 1982-84 = 100. Monthly changes in the CPI represent the rate of inflation.

The consumer price index is available nationally by expenditure category and by commodity and service group for all urban consumers (CPI-U) and wage earners (CPI-W). All urban consumers are a more inclusive group, representing about 87% of the population. The CPI-U is the more widely quoted of the two, although cost-of-living contracts for unions and Social Security benefits are usually tied to the CPI-W, because it has a longer history. Monthly variations between the two are slight.

The CPI is also available by size of city, by region of the country, for cross-classifications of regions and population-size classes, and for many metropolitan areas. The regional and city CPIs are often used in local contracts.

The Bureau of Labor Statistics also produces a chain-weighted index called the Chained CPI. This measures a variable basket of goods and services whereas the regular CPI-U and CPI-W measure a fixed basket of goods and services. The Chained CPI is similar to the personal consumption expenditure price index that is closely monitored by the Federal Reserve Board.

The consumer price index is the most widely followed monthly indicator of inflation. The relationship between inflation and interest rates is the key to understanding how indicators such as the CPI influence the markets.

The CPI is considered a cost-of-living measure since it is used to adjust contracts of all types that are tied to inflation. Labor contracts are tied to changes in the CPI; Social Security payments are tied to the CPI; and even tax brackets are tied to the consumer price index.

For monetary policy, the Federal Reserve generally follows “headline” and “core” inflation. This latter measure excludes the volatile food and energy components. The Fed’s preferred inflation measure is not the CPI but the personal consumption price index because it reflects what consumers are actually buying during any given period.

The component weights are updated annually while those for the CPI are updated infrequently. However, the subcomponent price data of the CPI are used to compile the PCE price index (PCE prices are released almost two weeks after the CPI). Thus, the CPI and the PCE price index are inextricably linked. In the long run, the overall CPI and core CPI track each other.

The bond market will rally (fall) when increases in the CPI are small (large). The equity market rallies with the bond market because low inflation promises low interest rates and is good for profits.

Economic data tends to be volatile from month to month, and the CPI is no exception. Large fluctuations in the consumer price index are often due to the food and energy components. Weather conditions affect both to a large extent. OPEC, the oil cartel, also affects energy prices. As a result, economists and financial market participants prefer to monitor the CPI excluding food and energy prices for its greater monthly stability. This is also referred to as the “core” CPI. Oddly enough, items that make part of the “core” also include discretionary goods and services. And while food and energy prices are excluded because of their monthly volatility, what can be more “core” than food and energy? Food and energy prices account for a little more than one-fifth of the CPI.

The consumer price index has evolved over time as consumer expenditures changed. Commodities now make up only 40%t of the index and the remaining 60% are services. It is useful to monitor goods and services separately since prices of goods are more volatile than prices of services.

Usually, when investors refer to the real rate of interest, they use the year-over-year rise in the CPI to subtract from an interest rate, such as the 10-year Treasury note. Consumer prices rose 2.5 percent from June 2004 to June 2005; the 10-year Treasury note averaged 4.0 percent in June 2005. The Treasury yield less the inflation rate put the real interest rate at 1.5 percent for the month.